An analyst is reviewing the financial statements of Horizon Corp, a U.S. company with operations in various countries. Horizon Corp uses the current rate method to translate the financial statements of its subsidiary in Country X. The functional currency of the Country X subsidiary is the local currency (LC). The analyst observes that Horizon Corp's consolidated balance sheet shows a significant increase in the cumulative translation adjustment (CTA) account during a period when the LC depreciated against the USD. Which of the following is the most likely explanation for this observation?
- AThe subsidiary's income statement items were translated at the historical exchange rate.
- BThe subsidiary had significant non-monetary assets that were translated at historical rates.
- CThe subsidiary had a net monetary liability position.
- DThe subsidiary had a net monetary asset position.
Show answer & explanationAnswer & explanation
Correct answer: C. The subsidiary had a net monetary liability position.
Under the current rate method, if the functional currency depreciates against the parent's currency, a net asset exposure will lead to a negative CTA, while a net liability exposure will lead to a positive CTA. An increase in CTA (implying a positive adjustment) when the LC depreciated suggests the subsidiary had a net monetary liability position.
Why the other options are wrong
- A. Incorrect. Under the current rate method, income statement items are translated at the average exchange rate for the period, not historical rates.
- B. Incorrect. Under the current rate method, all assets and liabilities, including non-monetary assets, are translated at the current exchange rate. Historical rates are used under the temporal method for non-monetary items.
- D. Incorrect. A net monetary asset position, when the local currency depreciates, would result in a negative translation adjustment (decrease or negative CTA), as assets translated at a weaker current rate are worth less in the parent's currency.
Current Rate Method - CTA Impact (Depreciation)
Under the current rate method, when the functional currency depreciates against the reporting currency, a net asset exposure leads to a negative Cumulative Translation Adjustment (CTA), while a net liability exposure leads to a positive CTA.
- All assets and liabilities translated at the current rate.
- Equity (except retained earnings) translated at historical rates.
- Income statement items at average rates.
- Translation gains/losses go to CTA, a component of Other Comprehensive Income (OCI).
Memory trick: Current Rate: Depreciating currency makes net liabilities a gain for CTA, while assets are a pain.